What's the difference between a Traditional IRA and Roth IRA? And how do you decide which one to use?
This question is one that doesn’t have a one-size-fits-all answer, and it’s likely that you will be better off if you figure out how to use both of these accounts throughout your life.
Let’s start at the beginning, you might be asking, "What the firetruck is an IRA?"
IRA stands for an Individual Retirement Account. Broken down further, the individual aspect means that an IRA will never, ever, be in more than one person’s name (with the exception of an inherited account, which will still have the deceased person in the title and the account owner would be listed like ‘Marsha Smith, Beneficiary of Marlene Smith’). There is no such thing as a joint IRA, which is why it’s a good idea to have retirement assets in both spouses names.
If you are many years from retirement age, DON’T tune this out! The further you are from retirement, the easier it is to save, and accumulate wealth. Plus, having a fat retirement account is cool af. Need more convincing? How about a quick game of 'Would You Rather?...'
Would you rather....
Be sipping mojitos on the beach in Portugal on your 60th birthday?
...or still working?
Would you rather....
Be able to give freely to your favorite charities?
...or have to wait until your too-small Social Security check arrives before you can buy eggs and milk?
Would you rather...
Save now, and retire early?
...or ignore saving, and work until you physically can't anymore?
Saving consistently and over a long period of time is the easiest way to create an ideal future for yourself. And the best way to do that is to utilize these retirement accounts.
Moving on, the ‘Retirement’ portion of IRA will abide by the IRS’s rules around retirement. Currently, you are not supposed to pull money out of your IRA’s before age 59.5 (come on, it’s for your retirement guys! (but hats off if you’re retiring before 59)). If you pull the money out prior, you risk being hit with an extra 10% penalty. There are exceptions and workarounds, as with most things finance and tax-related, but that’s for another article. Some people might say “Wahhh, but it’s MY money!”. Yes, it is your money, but you are getting some sick investment perks inside of this account, and the IRS isn’t just giving those out willy-nilly. It’s giving them to encourage people to save for their future. And penalizing withdrawals is a way to discourage your dirty, YOLO hands from the cookie jar of future you.
What are the perks you may ask? This is where we will break it down into the Traditional IRA versus Roth.
What's a Traditional IRA?
A traditional IRA is an investment account that allows you to save specifically for your future.
Tax-wise, the Traditional IRA works like a 401k or 403b does, and it’s perks are in the present. When you contribute to one of these accounts, you get to deduct your contributions from your income at the end of the year.
Example. Let’s say you make 50k a year, and you put 5k into a Traditional IRA. That 5k of contributions does not count as income this year- since you haven’t used it as such. That means it will be deducted, and your tax bill will be calculated as if you only made 45k that year.
Traditional IRA, 401k and 403b contributions are all deducted from your income the year they are contributed, meaning you are lowering your taxable income with every contribution, and saving in taxes that year.
Contributing to these accounts can also help you from going into a higher tax bracket, if you are on the threshold.
Let's look at our tax brackets to see how this could work.
2019 and 2020 Tax Brackets
Thank you for the tables, debt.org.
Let's say you're a single filer, and your taxable income is $164,000 in 2020. This income puts you in the 32% bracket, but just barely. If you were to contribute $5,000 to an IRA, you would lower your taxable income to $159,000, putting you back into the 24% bracket!
How is a Roth IRA different?
Roth contributions, on the other hand, are not deductible. You make Roth contributions with “after-tax” money, meaning you use earned-income, probably from a paycheck where all of your taxes were already taken out. If you contribute to a Roth, you don’t do anything come tax time. (But it is good practice to keep an accurate record of your contributions).
Well, why would you do that, if you can have the tax savings now?
Because it’s not just about now, it’s also about later.
It’s not easy to avoid taxes, and while retirement accounts have their tax perks, they certainly aren’t an exception. In Traditional IRA’s you are avoiding paying taxes today, and your money is allowed to grow, tax-deferred… until you pull it out. Since this money has never been taxed, all of your withdrawals from your IRA will be taxed as income.
When you pull money out of your Traditional IRA, expect to pay income tax (10%, 12%, 22%... whatever your tax bracket is, based on whatever the tax brackets are at that time). If you pull money out early, before age 59.5, you also might have to pay an additional 10% early withdrawal penalty. Ouchy. Don’t do that if you can avoid it.
Whereas in a Roth IRA, you already paid your taxes on the money you initially put in, so everything in it is yours, tax-free. If you pull Roth funds out early, the 10% penalty would apply to only the gains, not contributions. This works as a First In First Out (FIFO) method, so depending on what you have in there, you could avoid penalties altogether.
Example. Let’s say you have a Roth IRA that you have contributed 5k to every year for the last 10 years. You have contributed a total of 50k. If your account grew an average of 8% annually, after 10 years your balance would be just under $75k. You could pull out your 50k without incurring the 10% penalty, but anything over that 50k would be considered gains, and that portion would be penalized.
Thank you, Simple Savings Calculator from Bankrate!
And then once you pass age 59.5, all of that money in your Roth is yours, tax-free.
A Roth IRA is an amazing vehicle for everyone, but which IRA is right for you, or what combination of, is something that should be based on several factors.
We are in historically low brackets right now. This means that if you are contributing to a Roth, you are paying historically little tax, in the grand scheme of our tax history.
If you find yourself in the 10% or 12% bracket, then you are looking good for Roth contributions, because you are paying less in taxes. The higher your bracket, the more it makes sense to contribute to a Traditional IRA (or 401k/403b) to lower your tax burden now, while you are in a higher bracket.
The problem is, we have no idea what tax brackets will be in the future.
All we know is that they are not set in stone, and they have been ugly-high in the past.
In fact, following World War II, the highest tax bracket was 94%
When it comes down to making the decision of funding a Traditional or Roth IRA, ask yourself, are you more comfortable paying taxes now, or taxes later?
If you’re in a low tax bracket and like the idea of having a big, tax-free pot of money for future you, Roth that shiz up.
If you are in a higher tax bracket and contributing to a Traditional IRA will help you save in taxes today, go ahead and do that, and plan on making a Roth conversion in the future, in a lower-income year.
If you start saving for retirement in your 20’s, you truly have a lot of time to play with your contributions. Earning a good salary for a few steady years? Contribute to your 401k or Traditional IRA. Feeling burnt out and want to take 2 years off to travel? Plan Roth Conversions for the years where your income will be low, and you will be in a lower bracket, thus paying lower (or possibly no) taxes.
The idea of retirement accounts is to maximize the benefits and your tax savings. You are only able to do this if you understand how they are taxed!
I hope this was helpful! If you want to stay in the know on how to save for your future, join the Friend of Finance community below!
Hi, I'm Alicia, welcome to Friend of Finance! This site is a way for me to share helpful things I've learned from working in the financial industry, important money things that I probably wouldn't have learned otherwise, and things everyone should know about.